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Presented at the 5th Inter-University Graduate Student Conference at Cornell Law School, March 2009.

Abstract

The health of the economy and the effectiveness of monetary policy depend on a sound financial system. A smoothly functioning banking supervision regime is one of the cornerstones of any financial system. Only a stable financial system, which is one of the key aims of state regulation and oversight, can optimally fulfill its macroeconomic function of efficient and low-cost transformation and provision of financial resources. A global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The primary goals of supervision and regulations include protecting depositors' funds, maintaining a stable monetary system, promoting an efficient and competitive banking system and protecting consumer rights related to banking relationships and transactions.

Weakness in the banking system of a country, whether developing or developed, can threaten financial stability both within that country and internationally. The need to improve the strength of financial systems has attracted growing international concern. It is clear that instability in systemically significant countries can spill over to other countries, either on a regional level or globally.

There is a great deal of uncertainty around the nature of risks in the markets as well as many external risks, the adequacy of risk and what might trigger the next stress scenario. There is a lot that banks and supervisors can do in practice to better prepare for the inevitable next downturn. Banks and supervisors can focus their efforts on strengthening risk management in areas that presents the greatest vulnerabilities to the deteriorating market liquidity scenario, as well as on those risks that are not well addressed using more traditional risk metrics. Moreover, there is significant value in the industry and supervisors sharing insights on issues and concerns around this type of a scenario. Finally, Basel II provides a structured framework for discussing some of the new risks we are seeing and creating incentives to better measure and manage those risks.